Bad bank of the day, RBS edition

Here in the US, the bank-related scandals pertaining to the financial crisis invariably focus on the go-go years before everything fell apart, when the originate-to-distribute model created horribly skewed incentives across most of the privately-owned financial sector. In the UK, however, the latest big scandal is in many ways the exact opposite: it governs the behavior of RBS, one of the largest banks in the world, after the financial crisis, and after it was effectively nationalized by the UK government.

One of the problems with this story is that it’s hard to find a single place where the scandal is clearly laid out in its full gruesomeness. The BBC has done probably the best job, but most of the credit here really goes to the Sunday Times, which conducted a two-month investigation, and whose story (which is behind a subscription paywall, sorry) is a fantastic example of how a well-chosen set of individual stories can really bring systemic problems into focus.

And then there’s the Tomlinson Report. Lawrence Tomlinson is an entrepreneur and advisor to the government, and has delivered a 20-page paper entitled “Banks’ Lending Practices: Treatment of Businesses in Distress”. Its conclusions are clear — but its methodology is not, and I’m a bit sad that Tomlinson, after six months’ work, didn’t spend a little bit of effort to make the report more readable and provide detail on how exactly he arrived at his conclusions.

But putting everything together, a coherent narrative does emerge. Basically, after the crisis, RBS was in desperate straits, and had to deleverage fast — especially when it came to property loans. It gave that job to a bunch of bankers — and bankers, quite naturally, have a tendency to try to maximize their own profits. Which is exactly what they did, with no regard whatsoever to the wellbeing of their borrowers. Indeed, the bankers seemed to relish taking a maximally adversarial stance towards RBS’s borrowers, as though they were players in a zero-sum game. The result was a large amount of unnecessary human distress, on the borrower side, along with an unknown quantity of marginal extra profits on the RBS/taxpayer side.

It helps to look at a real-world example or two, otherwise everything is just too abstract. John Morris spent £65 million converting a country house into luxury apartments; he had another £2.5 million in the bank to cover any last-minute problems, and already had buyers lined up for four apartments worth £7 million. But then, without warning, RBS drained the account with £2.5 million in it, stalling the development, and causing the buyers to walk away. Morris tried to buy the whole thing for £32 million, but RBS said no, instead selling it to its own property division, West Register, for £16 million.

Here’s another: Eddie and Cheryl Warren bought the Bold hotel in Southport for £3.7 million, with a loan from RBS. In the UK, mortgages are floating-rate, and the bank forced them to take out an interest-rate swap to protect them against rising rates. When rates fell, they had to pay penalties on the swap of £120,000 per year — but even so, they always remained current on all their payments. That notwithstanding, RBS declared that thanks to the rate swap, the Warrens were deeply underwater. The bank declared the hotel to be worth just £1.8 million, forced the Warrens into insolvency, and then ended up selling the hotel to — yes — West Register, for the bargain-basement price of £1.4 million. The Warrens lost everything, including their home; they are now divorcing.

And then there’s Leonard Wilcox, who took out a £2.5 million loan to buy a property site valued at £5.35 million, only to see it being sold to West Register for £1.1 million in the end, losing his own home in the process.

The Sunday Times found lots of other stories like this, all of which included something called the Global Restructuring Group (GRG) at RBS. This group had the ability to take over loans and behave with breathtaking aggression and arrogance — and it took full advantage of all its powers.

Once you’ve read the Sunday Times story, the Tomlinson report becomes much easier to understand. The GRG would storm into a portfolio, and decide that its first job was to find something wrong. The trick was always to declare the borrower in violation of some covenant or other, even if she was fully current on her payments. Often, that would be done by writing down the value of property collateral.

On top of that GRG would pile fees onto the businesses it was given oversight of: one such business says that it had to pay an extra £256,000 in RBS fees alone, while others had to pay six-figure sums for external accountants to conduct an “independent business review”. None of this ever helped the businesses in question:

When asked, a whistleblowing ex-RBS banker confirmed that they could not think of any occasion in which a business entered RBS’ Global Restructuring Group and came back into local management.

Tomlinson, as befits a free-market entrepreneur, thinks that more competition would solve these problems. He’s wrong about that. Remember that all of this activity took place within a panicky post-crisis environment: no banks would have stepped in to take over these loans in mid-2009, no matter how many banks there were. And now that credit is flowing more easily again, the problems have gone away of their own accord: they were an artifact of their time. What’s needed is just better bank regulation, to make sure that banks don’t behave atrociously when the economy is going through a nasty recession. As part of that, banks should be encouraged not to mark real-estate collateral to market, in situations where the loans are not delinquent or past-due.

Tomlinson is right, however, that bank customers do need some kind of avenue of redress or complaint — in the UK, for these borrowers, there is essentially none, and they can’t even sue the banks, since any law firm which does business with banks will refuse to take their case.

There are broader lessons here, too, for anybody thinking about splitting troubled banks up into a good-bank / bad-bank structure. The problem with bad banks, which inherit troubled assets and try to wind them down with the minimum of losses, is that they can’t make money from lifetime relationships: their lifetime is by its nature highly limited. And so they have every incentive to treat their borrowers very badly, even when, as in this case, the bank is state-owned.